In this chapter we understand how two or more candlesticks can be combined to identify trading opportunities. To begin with we understand the bullish and bearish engulfing pattern with real examples f ..
In a single candlestick pattern, the trader needed just one candlestick to identify a trading opportunity. However, when analyzing multiple candlestick patterns, the trader needs 2 or sometimes 3 candlesticks to identify a trading opportunity. This means the trading opportunity evolves over a minimum of 2 trading sessions.
The engulfing pattern is the first multiple candlestick patterns that we need to look into. The engulfing pattern needs 2 trading sessions to evolve. In a typical engulfing pattern, you will find a small candle on day 1 and a relatively long candle on day 2, which appears as if it engulfs the candle on day 1. If the engulfing pattern appears at the bottom of the trend, it is called the “Bullish Engulfing” pattern. If the engulfing pattern appears at the top end of the trend, it is called the “Bearish Engulfing” pattern.
The bullish engulfing pattern is a two candlestick pattern which appears at the bottom of the downtrend. As the name suggests, this is a bullish pattern which prompts the trader to go long. The two-day bullish engulfing pattern is encircled in the chart below. The prerequisites for the pattern are as follows:
The thought process behind the bullish engulfing pattern is as follows:
The trade set up for the bullish engulfing pattern is as follows:
Needless to say, once the trade has been initiated, you will have to wait until the target has been hit or the stoploss has been breached. Of course, one can always trail the stop loss to lock in profits.
Have a look at DLF’s chart below; the bullish engulfing pattern is encircled.
The OHLC on P1 – Open = 163, High = 168, Low = 158.5, Close = 160. On P2 the OHLC details are – Open = 159.5, High = 170.2, Low = 159, Close = 169.
The trade set up for the bullish engulfing pattern is as follows:
In this example, both the risk-averse and the risk-taker would have been profitable.
Here is an example of a perfect bullish engulfing pattern formed on Cipla Ltd, the risk-averse trader would have completely missed out a great trading opportunity.
There is often a lot of confusion on whether the candle should engulf just the real body or the whole candle, including the lower and upper shadows. As long as the real bodies are engulfed in my personal experience, I would be happy to classify the candle as a bullish engulfing pattern. Of course, candlestick sticklers would object to this but what really matters is how well you hone your trading skills with a particular candlestick pattern.
So going by that thought, I’d be happy to classify the following pattern as a bullish engulfing pattern, even though the shadows are not engulfed.
The bearish engulfing pattern is a two candlestick pattern that appears at the top end of the trend, making it a bearish pattern. The thought process remains very similar to the bullish engulfing pattern, except one has to think about it from a shorting perspective.
Take a look at the chart below, the two candles that make up the bearish engulfing pattern is encircled. You will notice:
The trade set up would be as follows:
Take a look at the chart below of Ambuja Cements. There are two bearish engulfing patterns formed. The first pattern on the chart (encircled, starting from left) did not favour a risk-taker. However, the risk-averse would have completely avoided taking the trade. The second bearish engulfing pattern would have been profitable for both the risk taker and the risk-averse.
The OHLC data for the bearing engulfing pattern (encircled at the top end of the chart) is as below:
P1: Open – 214, High – 220, Low – 213.3, Close – 218.75
P2: Open – 220, High – 221, Low – 207.3, Close – 209.4
The trade setup for the short trade, based on the bearish engulfing pattern is as follows:
Both the risk-averse and the risk-taker would have been profitable in this particular case.
Now here is a fascinating chart. From my own personal experience, I can tell you, charts like the one shown below are highly profitable. One should not miss such trading opportunities
Take a look at the chart, what are the things that catch your attention?
What implication would a doji have in this chart?
Let us inspect this chart event by event:
From my own personal trading experience, I can tell you that whenever a doji follows a recognizable candlestick pattern, the opportunity created is bigger. Besides illustrating this point, I also want to draw your attention to chart analysis methodology. Notice in this particular chart, we did not just look at what was happening on P1 or P2. Still, we went beyond that and actually combined two different patterns to develop a comprehensive market view.
The piercing pattern is very similar to the bullish engulfing pattern with a minor variation. In a bullish engulfing pattern, the P2’s blue candle engulfs P1’s red candle. However in a piercing pattern P2’s blue candle partially engulfs P1’s red candle. However, engulfing should be between 50% and less than 100%. You can validate this visually or calculate the same. For example, if P1’s range (Open-Close) is 12, P2’s range should be at least 6 or higher,r but below 12.
As long as this condition is satisfied, everything else is similar to the bullish engulfing, including the trade set up. Here a risk-taker would initiate the trade on P2 around the close. The risk-averse would initiate the trade, the day after P2 only after ensuring a blue candle is formed. The stoploss would be the low of the pattern.
8.6 – The Dark Cloud Cover
The dark cloud cover is very similar to the bearish engulfing pattern with a minor variation. In a bearish engulfing pattern the red candle on P2 engulfs P1’s blue candle. However, in a dark cloud cover, the red candle on P2 engulfs about 50 to 100% of P1’s blue candle. The trade set up is the same as the bearish engulfing pattern. Think about the dark cloud cover as the inverse of a piercing pattern.
Typically stocks in the same sector have similar price movement. For example, think about TCS and Infosys or ICICI Bank and HDFC Bank. Their price movement is similar because they are more or less of the same size, have a similar business, and have the same external factors that affect their business. However, this does not mean their stock price movement would match point to point. For example, if there is negative news in the banking sector, banking stocks are bound to fall. In such a scenario if the stock price of ICICI Bank falls by 2%, it is not really necessary that HDFC Bank’s stock price should also fall exactly 2%. Probably HDFC Bank stock price may fall by 1.5% or 2.5%. Hence the two stocks may form 2 different (but somewhat similar) candlestick patterns such as a bearish engulfing and dark cloud cover at the same time.
Both these are recognisable candlestick patterns, but I chose between the two patterns to set up a trade. I would put my money on the bearish engulfing pattern as opposed to a dark cloud cover. This is because the bearishness in a bearish engulfing pattern is more pronounced (because it engulfs the previous day’s entire candle). On the same lines, I would choose a bullish engulfing pattern over a piercing pattern.
However, there is an exception to this selection criterion. Later in this module, I will introduce a 6 point trading checklist. A trade should satisfy at least 3 to 4 points on this checklist to be considered a qualified trade. Keeping this point in perspective, assume a situation where the ICICI Bank stock forms a piercing pattern, and the HDFC Bank stock forms a bullish engulfing pattern. Naturally, one would be tempted to trade the bullish engulfing pattern, however, if the HDFC Bank stock satisfies 3 checklist points, and ICICI Bank stock satisfies 4 checklist points, I would go ahead ICICI Bank stock even though it forms a less convincing candlestick pattern.
On the other hand, if both the stocks satisfy 4 checklist points, I will go ahead with the HDFC Bank trade.
Write a public review